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Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng Interdependence and Trade You wake up to an alarm clock made in Korea. You pour yourself some orange juice made from oranges grown in Malaysia. You put on some clothes made of cotton grown in USA and sewn in factories in Vietnam. You watch the morning news broadcast on your TV made in Japan. The bus you take is made of parts manufactured in a half-dozen different countries. Question: do you think, foreign trade can hurt a country? Under which circumstances do you think this could be possible? [Consider for example Thailand – China, Thailand – USA] In this chapter we will show that simple abstract models can give crystal-clear and simple answers to such complex questions! Additionally, we will introduce some useful concepts that will be helpful later. Interdependence and Trade Remember, economics is the study of how societies produce and distribute goods in an attempt to satisfy the wants and needs of its members. How do we satisfy our wants and needs in a global economy? We can be economically self-sufficient. We can specialize and trade with others, leading to economic interdependence.
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Page 1: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Interdependence andthe Gains from Trade

Comparative Advantage

Herbert Stocker

Institute of International StudiesUniversity of Ramkhamhaeng

Interdependence and Trade

You wake up to an alarm clock made in Korea.

You pour yourself some orange juice made fromoranges grown in Malaysia.

You put on some clothes made of cotton grown inUSA and sewn in factories in Vietnam.

You watch the morning news broadcast on yourTV made in Japan.

The bus you take is made of parts manufacturedin a half-dozen different countries.

Question: do you think, foreign tradecan hurt a country?

Under which circumstances do you think this could bepossible?

[Consider for example Thailand – China, Thailand –USA]

In this chapter we will show that simple abstractmodels can give crystal-clear and simple answers tosuch complex questions!

Additionally, we will introduce some useful conceptsthat will be helpful later.

Interdependence and Trade

Remember, economics is the study of howsocieties produce and distribute goods in anattempt to satisfy the wants and needs of itsmembers.How do we satisfy our wants and needs in a globaleconomy?

We can be economically self-sufficient.We can specialize and trade with others, leading toeconomic interdependence.

Page 2: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Interdependence and Trade

The theory of ‘Comparative Advantage’explains, why many economists are convinced,that free trade is better for a country as awhole than self-sufficiency!

This theory applies to countries as well as toindividuals or firms.

Comparative Advantage

“. . . this deepest and most beautifulresult in all of economics.”

(Findlay 1988, S. 514)

Founder: David Ricardo

David Ricardo (1772 - 1823)

A successful business man andbrilliant economist with exceptionalabilities for abstract reasoning.

Main Work: “Principles of PoliticalEconomy and Taxation” (1816)

“Ricardo conquered England ascompletely as the Holy Inquisitionconquered Spain”(Keynes 1936, S. 32)

Comparative Advantage

“If there were an Economist’s Creed, it

would surely contain the affirmations ‘I

understand the Principle of

Comparative Advantage’ and ‘I

advocate free trade’.”(Krugman 1987, p. 131)

Page 3: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Comparative Advantage

Who are the winners and loosers of free trade?

Are ‘poor’ countries worse off when trading with‘rich’ countries? (e.g. WTO-negotiations)

For understanding comparative advantage we needsome basic concepts, like . . .

Production possibilities frontierEfficiencyProductivityOpportunity cost

Comparative Advantage

Thought experiment:

Imagine a lonely and beautiful is-land, maybe somewhere in thesouth sea . . .

on this island, a lonely hunter . . .this man can either hunt or fish

if he hunts the whole day (10 hours) he can get 10 kgmeat (M).if he fishes the whole day (10 hours) he can catch 5 kgfish.

Comparative Advantage

The hunter faces a trade-off:

Hunter (A):

Meat Fish(M) (F )10 0.09 0.58 1.07 1.56 2.05 2.54 3.03 3.52 4.01 4.50 5.0

Production possibilities:

012345

0 1 2 3 4 5 6 7 8 9 10

bb

bb

bb

bb

bb

b

F

M

F = 5− 0.5M

Production Possibilities Frontier

0

1

2

3

4

5

0 1 2 3 4 5 6 7 8 9 10

efficient, maximal use of resources (time)technical possible,but not efficient!

F

M

Page 4: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Definitions

Production Possibilities Frontier: a graph thatshows the combinations of output that theeconomy can possibly produce given the availablefactors of production and available productionpossibilities (only for simplification we focus ononly two goods).

Efficiency: if it is not possible to increaseproduction of one good without producing less ofthe other good.

Productivity: the amount of output producedfrom one unit of input, e.g.

Labor productivity: the amount of outputproduced from each hour of a worker’s time.

Productivity

The PPF lies further to the right, . . .

→ the better the economy is endowed with factors,and

→ the higher is productivity.

F

M

Increase in laborproductivity in theproduction of F only

Productivity

(Labor-)Productivity (i.e. absolute cost ad-vantage) is the decisive factor for the (mate-rial) standard of living!

Determinants of Productivity:Physiscal Capital (machinery, etc.),Human Capital & Know-how,“Quality” of institutions and laws,and many more . . .

The higher productivity, the more goods areavailable (or people can work less, respectively)!

Question

Our hunter can either hunt 10 kg meat or 5 kg fish perday (10 hours).

What is the labor productivity if he hunts?1 kg meat per working hour.

What is the labor productivity if he fishes?0.5 kg fish per working hour.

Page 5: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Production Possibilities

Quiz: Which points are technical possible?

bc

bc

bc

bc

bc

bc

bc

bc

bc

bc

bc bc

bc bc

A

BC

D

E

F

G

H

I

J

K L

MN

Y

X

Solution: A,B,D,E,F,M,H,I,K

Production Possibilities

Quiz: Which points are technical efficient?

bc

bc

bc

bc

bc

bc

bc

bc

bc

bc

bc bc

bc bc

A

BC

D

E

F

G

H

I

J

K L

MN

Y

X

Solution: B,D,F,H,K

Production Possibilities

Quiz: Which points are technical inefficient?

bc

bc

bc

bc

bc

bc

bc

bc

bc

bc

bc bc

bc bc

A

BC

D

E

F

G

H

I

J

K L

MN

Y

X

Solution: A,E,M,I

Production Possibilities

Quiz: Which points are technical impossible to realize?

bc

bc

bc

bc

bc

bc

bc

bc

bc

bc

bc bc

bc bc

A

BC

D

E

F

G

H

I

J

K L

MN

Y

X

Solution: C,G,J,N,L

Page 6: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Opportunity Cost

If we decide for one alternative, we have usually tosacrifice other alternatives, since our resources(e.g. time, money, . . . ) are scarce.

There is a trade-off between alternatives.

The Opportunity cost of one chosen alternativeare the cost of the next best alternative we had tosacrifice.

Opportunity Cost

If our lonely hunter wants one additional kg fishhe has to sacrifice 2 kg meat (i.e. he must fishadditional 2 hours instead of hunting!)

The opportunity cost of 1 kg fish is 2 kg meat.

If our lonely hunter wants an additional kg meathe must sacrifice 0.5 kg fish (i.e. hunt 1 additionalhour instead of fishing!)

The opportunity cost of 1 kg meat is 0.5 kg fish.

Opportunity Cost . . .

. . . is the slope of the production possibilities frontier!

0

1

2

3

4

5

0 1 2 3 4 5 6 7 8 9 10

F = 5− 0.5M or M = 10− 2FF

M

∆M = +1

∆F = −0.5

∆F∆M = −0.5∆F = +1

∆M = −2∆M∆F = −2

Opportunity Cost

The slope of the production possibilitiesfrontier measures the opportunity cost!The slope is the derivative of a function

F = 5− 0.5M

Opportunity cost of Meat:

dF

dM= −0.5

M = 10− 2F

Opportunity cost of Fish:

dM

dF= −2

Opportunity cost of fish is the reciprocal ofopportunity cost of meat.

Page 7: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Slope and Angle

The slope of a linear function can also be calculated asthe tangent of an angle:

Hypotenuse

Adjacent

Oppositeleg

α

tanα =Opposite leg

Adjacent

= Slope

Opportunity Cost

012345

0 1 2 3 4 5 6 7 8 9 10

α

F

M

Opportunity cost ofmeat:

F = 5− 0.5MdF

dM= −0.5

tanα =Opposite leg

Adjacent

=5

10= 0.5

One kg meat “costs” the lonely hunter 0.5 kg fish!

Opportunity Cost

012345

0 1 2 3 4 5 6 7 8 9 10

β

F

M

Opportunity cost offish:

M = 10− 2FdM

dF= −2

tan β =Opposite leg

Adjacent

=10

5= 2

One kg fish “costs” the lonely hunter 2 kg meat!

Opportunity Cost

0

1

2

3

4

0 1

Fish (F )

Meat (M)

α

β

Production possibility frontier of Mr.Fisher from the neighboring island:

F = 4− 4M ,dF

dM= −4

tanα =Opposite leg

Adjacent=

4

1= 4

M = 1− 0.25F ,dM

dF= −0.25

tanβ =Opposite leg

Adjacent=

1

4= 0.25

Page 8: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Productivity

Labor productivity in the production of . . .Fish Meat

Hunter 0.5 kg Fish/Hour 1 kg Meat/HourFisher 0.4 kg Fish/Hour 0.1 kg Meat/Hour

⇒ The hunter is more productive in hunting andfishing! (and has therefore probably a higher standard of living)

Should the fisher and hunter trade with each other???

Opportunity Cost

Labor productivity in the production of . . .Fish Meat

Hunter 0.5 kg Fish/Hour 1 kg Meat/HourFisher 0.4 kg Fish/Hour 0.1 kg Meat/Hour

Opportunity Cost ofFish Meat

Hunter 1 kg Meat/Hour0.5 kg Fish/Hour =

2 kg Meat1 kg Fish

0.5 kg Fish/Hour1 kg Meat/Hour =

0.5 kg Fish1 kg Meat

Fisher 0.1 kg Meat/Hour0.4 kg Fish/Hour

= 0.25 kg Meat1 kg Fish

0.4 kg Fish/Hour0.1 kg Meat/Hour

= 4 kg Fish1 kg Meat

Opportunity Cost – Comparative Adv.

Opportunity Cost ofMeat Fish

Hunter 0.5 kg Fish 2 kg MeatFisher 4 kg Fish 0.25 kg Meat

The hunter has lower opportunity costs inproducing meat (for one additional kg meat thehunter has to sacrifice 0.5 kg fish, the fisher hasto sacrifice 4 kg fish for one additional kg meat).

It follows automatically, that the fisher has loweropportunity costs in producing fish!

Comparative Advantage

Example: Opportunity Cost of Meat of Fish

0

1

2

3

4

0 1 2 3 4 5 6 7 8 9

Fish

Meat

α

γ

β

δ

Meat:α < β⇒

Hunter

Fish:δ < γ⇒ Fisher

Page 9: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Two Kinds of Cost

Absolute Cost: how many hours are needed toproduce one unit of a good.

Absolute Advantage: the country with thehigher productivity has an absolute advantage!

Opportunity Cost: which alternatives we haveto give up to produce one more unit of a good(i.e. how many units of the other good have to besacrificed to produce this one more unit)?

Comparative Advantage: the country with thelower opportunity cost has an comparativeadvantage!

Opportunity Cost – Comparative Adv.

For the gains from trade is not productivity (orabsolute cost) relevant, but only opportunitycost!

Everyone should specialize in the production ofthe good, where he or she has the loweropportunity cost!!!

Since opportunity cost is the slope of theproduction possibilities frontier, both parties willgain as long as the exchange ratio is between theslopes of the individual production possibilitiesfrontiers!

Example

Autarkie (no trade):

Consumption possibilities = Production possibilities

Production Trade ConsumptionHunter 6 kg Meat 0 6 kg Meat

2 kg Fish 0 2 kg FishFisher 2 kg Fish 0 2 kg Fish

0.5 kg Meat 0 0.5 kg Meat

Comparative Advantage

Example: Autarky (no trade):

0

1

2

3

4

0 1 2 3 4 5 6 7 8 9

Fish

Meat

bc bc

bc Production andConsumptionunder autarky

(Any other point onthe PPF is possibleas well.)

Page 10: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Example

With Trade:for simplicity we assume an exchange ratio 1:1

Consumption possibilities > Production possibilities

Production Trade ConsumptionHunter 10 kg Meat – 2 kg Meat 8 kg Meat

0 kg Fish + 2 kg Fish 2 kg FishFisher 4 kg Fish – 2 kg Fish 2 kg Fish

0 kg Meat + 2 kg Meat 2 kg Meat

Gains from Trade: Hunter: + 2 kg MeatFisher: + 1.5 kg Meat

Comparative Advantage

Example: Trade with an exchange ratio 1:1(assumption)

0

1

2

3

4

0 1 2 3 4 5 6 7 8 9

Fish

Meat

bc bcut ut

rs

rs

bc Production andConsumptionunder autarky

rs Productionwith trade

ut Consumptionwith trade

Result

Not the location of the productionpossibilities frontier (productivity) isdecisive whether trade is advantageous,but the slope of the productionpossibilities frontier (i.e. OpportunityCost)!

Question

Should George Clooney ironhis shirts himself, even if heshould be a world championin ironing?

Page 11: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Comparative Advantage

Without trade production possibilities determineconsumption possibilities!Without Trade:Production possibilities = Consumptionpossibilities

Trade allows to increase consumption possibilities!With Trade:Consumption possibilities > Productionpossibilities

Free trade makes both parties better off, sincetrade allows to make a more efficient use of theavailable resources!!!

Absolute vs. Comparative Advantage

Summing up . . .

Whenever the opportunity cost of two tradingpartners differ both parties will profit from trade!

A country could have an absolute disadvantage inthe production of all goods, but it is logicallyimpossible that a country has an comparativedisadvantage in the production of all goods!

For the gains from trade only comparativeadvantages are relevant, absolute advantage isirrelevant!

An Example

Comparative Advantage: ExampleProductivities:

Amount producedin one hour

Cheese BreadEngland 40 20Spain 30 5

Endowment with labor:

England: 10 hours

Spain: 20 hours

England’s production possibility frontier is

B = 200− 0.5C

Spain’s production possibility frontier is

B = 100− 1/6C

Why?

Page 12: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Comparative Advantage: Example

Productivities:

Amount producedin one hour

Cheese BreadEngland 40 20Spain 30 5

Endowment with labor:

England: 10 hours

Spain: 20 hours

0

100

200

0 100 200 300 400 500 600

B

C

Engl.: B = 200− 1/2C

Spain: B = 100− 1/6C

Comparative Advantage: Example

PPF England:B = 200− 1/2C orC = 400− 2B

Opportunity cost ofBread in England:

OCB =40C/h

20B/h

=400C

200B

= −dC

dB= 2C/B

PPF Spain:B = 100− 1/6C orC = 600− 6B

Opportunity cost ofBread in Spain:

OCB =30C/h

5B/h

=600C

100B

= −dC

dB= 6C/B

Comparative Advantage: Example

PPF England:B = 200− 1/2C orC = 400− 2B

Opportunity cost ofCheese in England:

OCC =20B/h

40C/h

=200B

400C

= −dB

dC= 1/2B/C

PPF Spain:B = 100− 1/6C orC = 600− 6B

Opportunity cost ofCheese in Spain:

OCC =5B/h

30C/h

=100B

600C

= −dB

dC= 1/6B/C

Comparative Advantage: Example

England has lower opportunity cost in theproduction of bread, and should thereforespecialize in the production of bread.

Spain has lower opportunity cost in the productionof cheese, and should therefore specialize in theproduction of cheese.

Trade will make the world a better place, sinceEngland and Spain as countries are better of byspecializing and trading.

However, British cheese maker and Spanish bakerwill not be amused!

Page 13: Interdependence and the Gains from Trade - …Interdependence and the Gains from Trade Comparative Advantage Herbert Stocker Institute of International Studies University of Ramkhamhaeng

Summary

Free trade can increase welfare of all trading

partners, since free trade allows a more

efficient allocation of resources!

By a more efficient allocation of resources it isusually possible to produce more of both goods!

However, some groups may loose, though thegains of the Winners will generally exceed tolosses of the losers; more on this later

Nonlinear PPF

Production possibilities frontier are often bowedoutward. One reason for this is, that opportunity costoften increase as more resources go in the productionof one good.

F

M

Opportunity cost aremeasured as the slopeof a tangent in therelevant point!

Comparative Advantage

International Trade:

Example of David Ricardo: England and Portugaltrade cloth for wine.

Specialization necessitates structural change!People have to change jobs, and if they are notmobile between industries many will loose theirjobs!!!

Structural change implies adjustment costs in theshort run, but can increase welfare in the long run!

Sources of Comparative Advantage

International differences in climate and naturalresources.

Technology.

Factor endowments: The relationship betweencomparative advantage and factor availability isfound in an influential model of internationaltrade, the Heckscher-Ohlin model.


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